Understanding High-Yield Bond Spreads: Definition and Investment Insights

What Is a High-Yield Bond Spread?

A high-yield bond spread measures the difference in yields between high-yield (junk) bonds and safer benchmarks such as investment-grade corporate or government bonds, usually expressed in percentage or basis points.

This spread reflects the additional credit risk investors take on for the higher potential returns offered by riskier issuers. Widening or narrowing spreads provides insight into economic conditions and credit market sentiment, signaling shifts in perceived default risk and investor confidence.

Understanding the Mechanics of High-Yield Bond Spreads

A high-yield bond, also known as a junk bond, is a type of bond that offers a high rate of interest because of its high risk of default. Though high-yield bonds have lower credit ratings than government or investment-grade bonds, their higher interest rates attract investors. The high-yield sector has a low correlation to other fixed income sectors and has less sensitivity to interest rate, making it a good investment asset for portfolio diversification.

The greater the default risk of a junk bond, the higher the interest rate will be. One measure that investors use to assess the level of risk inherent in a high-yield bond is the high-yield bond spread. The high-yield bond spread is the difference between the yield for low-grade bonds and the yield for stable high-grade bonds or government bonds of similar maturity.

As the spread widens, the perceived risk and potential returns on junk bonds both increase. The higher yield bond spread is, therefore, a risk premium. Investors will take on the higher risk prevalent in these bonds in return for a premium or higher earnings.

High-yield bonds are typically evaluated on the difference between their yield and the yield on the U.S. Treasury bond. A company with weak financial health will have a relatively high spread relative to the Treasury bond. This is in contrast to a financially sound company, which will have a low spread relative to the US Treasury bond. If Treasuries are yielding 2.5% and low-grade bonds are yielding 6.5%, the credit spread is 4%. Since spreads are expressed as basis points, the spread, in this case, is 400 basis points.

Advantages of Analyzing High-Yield Bond Spreads

High-yield spreads are used by investors and market analysts to evaluate the overall credit markets. The change in the perceived credit risk of a company results in credit spread risk. For example, if lower oil prices in the economy negatively affect a wide range of companies, the high-yield spread or credit spread will be expected to widen, with yields rising and prices falling.

If the general market’s risk tolerance is low and investors navigate towards stable investments, the spread will increase. Higher spreads indicate a higher default risk in junk bonds and can be a reflection of the overall corporate economy (and therefore credit quality) and/or a broader weakening of macroeconomic conditions.

The high-yield bond spread is most useful in a historical context, as investors want to know how wide the spread is today compared to the average spreads in the past. If the spread is too narrow today, many savvy investors will avoid buying into junk bonds. High-yield investments are attractive vehicles for investors if the spread is wider than the historical average.

The Bottom Line

A high-yield bond spread, or credit spread, measures the yield gap between high-yield bonds and safer benchmarks like Treasuries, highlighting the trade-off between higher income and greater default risk.

Wider spreads often signal rising economic uncertainty, making spread trends and historical comparisons valuable for market assessment. Though riskier, high-yield bonds can enhance diversification due to their lower correlation with traditional fixed-income assets.